The Heritage Foundation

Backgrounder #389 on Agriculture

October 30, 1984

October 30, 1984 | Backgrounder on Agriculture

The Free Market Answer to U.S. Farm Problems

(Archived document, may contain errors)

389 October 30, 1984 THE FREE MARKET ANSWER TO U.S. FARM PROBLEMS INTRODUCTION Today's agr icultural programs remain much as they were when originally instituted during the Roosevelt New Deal era.l is different is that the contention that these programs are necessary and beneficial to the public is being challenged is now widely understood, for instance, that government-enforced restrictions on competition lead to higher domestic prices for milk, sugar, oranges, and other products. There is growing concern, moreover, about the soaring costs to the taxpayer of agricultural programs. Price support activities alone have increased from $4 billion in Fiscal 1980 to about $20 billion in 1983 What It Most farm program benefits are enjoyed by farmers with large operations whose incomes already exceed, on average, those in the nonfarm sector specialized f arm resources, since the higher product prices received by farmers eventually are offset in large part by higher production costs made possible by the output price guarantees.

Price supports and subsidized credit programs also encourage farmers to invest i n land and capital facilities when there is already widespread concern about farm size and debt. Finally marketing orders, import controls, price supports, and other These programs mainly assist owners of land and This paper is the third in a series descr ibing these programs. It was preceded by Bruce Gardner Agriculture's Revealing--and Painful--Lesson for Industrial Policy," Heritage Foundation Backgrounder No. 320, Jan uary 3, 1984; and E.C. Pasour, Jr The High Cost of Farm Subsidies,"

Heritage Foundation Backgrounder No. 388, October 22, 1984.

G. Edward Schuh Future Directions of Food and Agricultural Trade,"

American Journal of Agricultural Economics, May 1984, p. 242. 2 restrictions on competition not only distort the allocation of resources, but als o restrict the freedom of individuals to enqage in mutually beneficial exchange and are inconsistent with achiev- ing a more open economy agricultural policies do not serve the public interest. programs instead are a form of income redistribution. ti-on-, - other-federal policies have done much to hurt farmers. Inflationary monetary and fiscal policies, for instance, along with subsidized credit and trade restrictions, have fostered instability in agriculture. moreover, that agriculture is different from oth e r economic sectors, in the sense that the competitive market process is incapable.of coordinating its economic activity. And with the products of two bf every five cultivated acres in the U.S. now sold abroad, farmers will suffer seriously from any govern ment policies that encourage protectionism.

Next year a new farm bill will be introduced in Congress to reauthorize existing farm programs. This bill is likely to be a watershed for U.S. agricultural policy if legislators use the opportunity to debate the fundamentals of farm policy. Only two basic choices existfor U.S. agriculture 1) continuing and extending those protectionist policies that support U.S. farm prices above world market levels and assist and protect domestic producers through export subsidi e s and import controls 2) opening the U.S farm economy so that resource use and producer returns are determined through the market process There is a qreat deal of evidence, therefore, that government Farm In addi There is no persuasive evidence In a more o pen economy, milk, wheat, sugar, and other product Prices of credit and other subsidized inputs would rise prices would fall, reflecting underlying demand and supply condi- tions. to reflect the cost of these resources in other uses. Government would enco u rage rather than impede the development of options markets and other market institutions through which farmers could reduce the risks in production and marketing. The U.S. government could spur trade by reducing its own trade barriers and working to reduc e trade restrictions on other countries. Finally, the adoption of noninflationary federal monetary and fiscal policies would increase economic stability in agriculture, just as it would in other sectors of the economy Ibid on international trade during the 1970s exports of farm products have decreased substantially since 19

81. For example, the acre equivalent of the decrease in exports of corn, cotton, wheat, and soybeans from 1980 to 1983 was 22.6 million acres. The combination of the decrease in exports and protectionist domestic farm policies has resulted in a ballooning of the cost of farm programs Following a large increase in the dependence of U.S agriculture 3 THE ENTREPRENEURIAL MARKET PROCESS The underlying problem in agriculture, as in any other s ector of the economy, is how to secure the best use of resources, available to any of the members of society, for ends whose rela- tive importance only these individuals can determine thi's foundation for economic action, there are two known ways of secur i ng economic cooperation--the market system and central direction. The market system does what central planning cannot it utilizes the detailed information contained in millions of minds that cannot be articulated and conveyed to a central authority in a s t atistical form.5 In achieving spontaneous coordination, the price system provides the signals and the incentives for consumers and producers to alter their behavior in making consumption and production decisions compatible government raises the price of m i lk above the market price, which balances supply and demand, producers are induced to produce Iltoo muchll and consumers to consume Iftoo little." The result: costly surpluses. Market prices therefore provide correct signals to producers and consumers onl y when prices are free to change in response to changing economic conditions.

Profit and loss signals provide the fundamental driving force for change and progress in a private enterprise system. the market, economic change and progress in agriculture (and in other sectors is characterized by business experimentation. Entrepreneurial decisions are guided by perceptions of profit opportunities, and where there are no government subsidies or "soft loansii to failinq firms, only those enterprises that best an t icipate market conditions remain in business. In this way, market forces shift resources away from 1ess.productive farms. Consequently, since the'level of profits is determined by how well decision makers have anticipated market conditions, profit and los s signals are a measure ofthe respons.iveness of producers to consumers.

The market, then, is a discovery process in which informa- tion is directed to those who can best use it be fully effective only if price and profit signals reflect the underlying dem and and supply conditions Given Government intervention distorts this coordination. When In This process can Price supports, credit F. A. Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948 p. 78.

Leland B. Yeager and David G. Tuerck, "Realism and Free-Trade Policy,"

Cat0 Journal, Winter 1983/1984, pp. 645-6

66. John Burton, Picking Losers Policy (London: Institute of Economic Affairs, 1983 F. A. Hayek, "Competition as a Discovery Procedure," Chap ter 12 in New Studies in Philosophy, Politics, Economics and the History of Ideas Chicago The Political Economy of Industrial University of Chicago Press, 1978). 4 subsidies, marketing orders, and other government programs only hamper and stifle the entre preneurial discovery process, thereby distorting the allocation of resources and the pattern of produc- tion.

The only alternative to the market process is central direc- tion. The political process accompanying such direction, however, is subject to formi dable information and incentive problems. principle, central planners could solve the economic coordination problem if full information were available to them and the incen- tive problems could be overcome In reality, information problems are endemic in g o vernment programs because of the separation of power and knowledge. In the case of subsidized credit by the Farmers Home Administration E"A for instance, F'mHA officials cannot objectively determine the demand for so-called limited resource loans and deci d e which farmers "need a lower interest rate to have a reasonable chance of success.tf8 Also inherent are incentive problems in which decision-making power is separated from responsibility. The fortunes of FmHA lending officials, for example, are affected relatively little by the success or failure of farmers receiving loans. When farm credit is available only from commercial firms whose loan officers are answerable to the stockholders, on the other hand, there is a strong tendency against overexpansion.

Th e market process is fueled by entrepreneurial profits and losses. Indeed, the occurrence of losses and business failure is a major factor in the process leading to a more efficient use of resources. But this loss-making function is likely to be impeded by credit subsidies, moratoriums on E"A foreclosures, and other agricultural policies that substitute political judgment for the discipline of the market. Even if the information problem could be solved and the successes or difficulties of farms predicted in . such cases, the decision to assist economically distressed farms political considerations spontaneous coordination of decentralized decisions in the market process .g tives, and responsibility are largely fragmented and uncoordinated. The manipulation of government policies for political purposes is 'a case in point. io In I i would likely be dominated or heavily influenced by short-run I In sum, nothing in the political process corresponds to the In the political arena, knowledge, authority, incen The hi ghly visible political advantages of U.S. Department of Agriculture, A Brief History of Farmers Home Administra tion (Washington, D.C U.S. Government Printing Office, 1983 p. 15.

End B. Yearrer Is There a Bias Toward Overrenulation Chapter 4 in I I Tibor R. Machin and M. Bruce Johnson (eds Rights and Regulation Ethical, Political, and Economic Issues (San Francisco for Public Policy Research, 19831, p. 1

00. Pacific Institute io Edward R. Tufte,-Political.Control of the Economy (Princeton, New Jersey Princ eton University Press, 1978 5 increased agricultural price supports or Social Security benefits, for example, are realized quickly, whereas the costs are diffuse and borne in the long run by taxpayers, who have no opportunity to vote on any one of these i ssues on its own merit.

WHY GOVERNMENT INTERVENES IN AGRICULTURE There are two competing hypotheses to explain government intervention in agriculture: redistribution. the public interest and income The Public Interest The public interest justification hold s that aqricultural policy is designed largely to increase stability arising from variability in crop yields and prices. It is argued by advocates' of government intervention that lower income for farm labor means that there is a resource allocation and i n come distribution problem. because of changing market and weather conditions implies a stabilization problem. ltproblernslt often are defended on public interest grounds Similarly, the fact that prices vary from year to year So government programs to deal with these Income Redistribution Income redistribution for some public puqose is another jus- tification often used for government intervention in agriculture. There must be federal programs it is said, to ensure that farmers receive an adequate income fo r their essential work by redistrib- uting income from more affluent sectors I The problem is that many farm programs seem designed less to achieve such public objectives than to engage in rent seeking (that is, economic benefits through political action) f or indi- vidual purposes. Why, for example, are domestic producers of cheese, butter, or sugar given protection against cheaper imports? Is it because dairy or sugar producers have low incomes (and these markets are unstable) or because they have effectiv e political lobbies? consistent with the evidence. The role of Political Action Committee (PAC) contributions by big dairy co-ops in enactment of the 1983 dairy bill, from which some dairy producers will receive more than 1 million-cited as the "biggest vi c toryi1 ever fpr the dairy lobby-is hardly consistent with any.supposedly lofty ideal of transferring income to poor farmers tobacco program, peanut program, wheat program, and programs for many other commodities. In each case, the benefits are concen- tra t ed on a relatively small number of producers, and the costs are spread thinly across a much larger group of taxpayers and consumers small, the potential producer payoff is large enough to induce sugar producers and other commodity groups to organize in po l itical The latter explanation appears to be more The results are similar in the case of the sugar program Although program costs to individuals are quite 6 attempts to achieve income transfers through the use of government power. Legislators, as part of a political process biased toward the short run, have incentives to respond. There is a great deal of casual evidence that price support programs interest rate subsidies, and other programs to increase farm incomes are ex- plained better by the attention to income redistribution rather than to the public interest THE ROLE OF GOVERNMENT IN MARKET-ORIENTED AGRICULTURE Agricultural programs, especially price supports and subsi- dized credit, pose three types of costs 1 since the most profitable pattern of produ ction and resource use is distorted by price supports and subsidized inputs.

These policies impede the market discovery process 2) The programs delay economic adjustment. Consider the extension of credit on easy terms to farmers in financial diffi fanners in business whose credit standing is too poor to qualify for loans from commercial banks. In too many cases, the result is merely to postpone failure until the next round of depressed prices action committees (PACs farm organizations, and commodity groups , divert resources from the task of production to the scramble to obtain and retain government transfers.

There is no convincing evidence that agriculture is different from other economic sectors, in the sense that the competitive market process is fundame ntally incapable of coordinating economic activity in agriculture. In fact, there is a significant sector of agriculture, including soybeans, many fruits and vegetables, poultry and livestock, in which there are no effective price support programs. This l a rgely unregulated sector of agriculture accounts for about half to two-thirds of U.S. farm production. Government-promoted and sanctioned cartels in the production of milk, tobacco, peanuts, sugar, and other products are no more defensible (or consistent w ith government antitrust policies than similar restrictions on competition in other areas of the economy. culty. "Economic emergency" and other subsidized loans keep some 3) These programs, as evidenced by expenditures of political It is increasingly bein g recognized that the U.S. cannot be a credible proponent of free trade as long as it indulges in protectionist domestic agricultural policies. Domestic agricul- tural programs require import restrictions on dairy products, tobacco, suqar, oranges, and oth e r products. As the dependence of U.S. agriculture on exports increases, the liberalization of trade becomes increasingly important. The U.S. government can facilitate trade both by reducing its own trade barriers and by working to reduce trade barriers on the part of other countries, including the European Common Market countries, in which price support programs have resulted in the accumulation of government- owned stocks Why Government Should Do Less A primary policy goal should be to ensure that governm e nt policies do not create artificial instability in acp-icultural markets. In view of the inherent information and incentive problems, government may make its greatest contribution to agri- culture (and to the overall economy) by doing less.ll some of the ways in which government actions destabilize the economy.

First, monetary disturbances affect rei-ative prices. This is particularly true of interest rates, a key factdr inahvest- ment decisions. which is characterized by a high rate of capital investment per unit of labor. Many of the widely publicized farm bankruptcies of recent years have involved heavily leveraged operations in which money was borrowed at the historically high interest rates of the late 1970s. And the anticipated inflation, primary ca u se of such high interest rates and the product of government's monetary and fiscal policies, has in effect caused major problems in the farm sector Consider Interest rates are very important in agriculture Second, administrations often manipulate short-ru n policies hoping to affect upcoming elections. For instance, Yale economist Edward Tufte, studying the period from 1947 to 1976, found a two-year political business cycle during which real income growth increased in eight of eleven election years as a res u lt of in- creases in transfer gayments, including Social Security and veterans benefits. Agricultural programs provide another avenue through which an Administration can manipulate short-run policies for political advantage. Prior to the 1976 election, fo r example, the Ford Administration raised the loan rate on wheat from 1.50 to $2.25 per bushel and tripled the tariff on imported sugar. supports significantly on the eve of the 1980 e1ection.l And President Carter increased dairy grice Third, subsidized c r edit Programs operated by the Farmers Home Administration create an incentive to expand the size of farm operations through borrowing. When the cost of capital is decreased, farmers are induced to substitute capital for labor Paul Heyne, The Economic Way of Thinking (Chicago Science Research Associates li! Edward Tufte, op.'cit l3 Bruce L. Gardner, The Governing 'of Agriculture (Lawrence, Kansas Press of Kansas. 1981 D. 118.

Regents I l4 Dale Heien, "Future Directions for U.S. Food, Agricultural, and Trade Policy: Discussion American Journal of Agricultural Economics, May 1984 p. 232. 8 It is likely that easy government credit has been a factor con- tributing to the recent increase in farm bankruptcies.15 trade and, consequently, is greatly affected by gov e rnment policies affecting trade. Soviet Union by President Jimmy Carter in 1980, for example, greatly increased uncertainty in domestic grain markets, since it meant that supply, demand, and price turned on foreign policy factors that could change daily. H owever, it is not only the measures directly affecting agricultural exports that are im- portant. During the recent recession, for example, the Reagan Administration's ostensibly free trade policies succumbed to political pressures, as import restrictions were tightened for autos, steel, textile products, motorcycles, and other items. Foreign buyers, however, must have dollars from their exports to buy U.S. farm products. Consequently, voluntary or nonvoluntary import restrictions on autos, steel, and othe r products are especially damaging to agriculture Fourth, agriculture is heavily dependent on international The suspension of grain sales to the Much of the instability of U.S. commodity markets during the past decade can be traced to government policies.1 6 Therefore, government would make an important contribution to the stability of agricultural markets by reducing voluntary potas and other trade restrictions, by eliminating credit subsidies, and perhaps most important, by following noninflationary moneta ry and fiscal policies.

Developing Market Institutions to Reduce Risk I I Government also can create a climate to facilitate rather than impede the development of institutions dealing with weather and market risks. Consider the example of crop insurance As a large loss, insurance is a key means of copinq with risk in many areas of life. The current government-subsidized crop insurance program, however, in effect bars crop insurance by private firms It may be that farmers would not be willing to pay the ful l cost of crop insurance. levels high enough to cover costs is sometimes taken as evidence I device to substitute a small, known cost for the possibility of a I I The lack of participation at premium l5 Michael T. Belongia, Agriculture: An Eighth District Perspective (St.

Louis, Missouri Although farm bankruptcies have been much in the news during recent years, the bankruptcy rate does not appear to be higher in agriculture than in the nonfarm sectors of the economy The instability of U.S. commodity markets during the 1970s and early 1980s has been largely a monetary phenomenon, not a weather phenomenon as is so commonly believed G. Edward Schuh, op. cit., p. 2

44. Other countries as well as the United States contributed to the monetary in stability Federal Reserve Bank of St. Louis, Spring 1984 l6that' subsidized crop insurance is warranted follows if real world markets are measured against the norm of perfect competition,I where all risks would be insured the real world, where risk reduction is achievable only at a cost it is economic to shift risk only when the expected gains 1ejcee.d the costs evidexke of an unwillingness to shift risk to others at premium l evels that cover the full cost of providing the insurance.l2 Whether crop insurance is economic can be determined only through a market test This conclusion But in Thus, the absence of insurance merely is The futures market is an important means of shifti n g risk in the production of crop and livestock products for which futures markets exist Although trading in futures for agricultural products is now limited to about one year from the current period it might be possible to develop selected futures contrac t s two or three years into the the projected price patterns on the basis of expected demand and supply conditions and then announce the price band within which it would buy or sell contracts maturing more than nine months in the future. Theoretic a lly, such a mechanism would provide a relatively stable environment in which producers could hedge production and storage decisions over a longer period all other actions by agencies in which power and responsibility are separated. Moreover the enormous p r oblems associated.with obtaininq sufficient information to make rational decisions are largely ignored forecast accurately future demand and supply conditions for agricultural products. Economic prediction of general economic conditions even one year in a dvance has proved to be beyond the capability of economic forecasters ment can make the greatest contribution in the case of futures markets by providing a stable legal framework.

Option markets provide a potentially attractive alternative for current gove rnment programs in insuring against risk in agricultural markets Example: A corn farmer at planting might purchase a IlputlI option giving him the right to sell a corn futures contract at harvest at a specified price. If the market price of corn at harves t exceeds the specified price, the option need not be exercised, and the fader could sell his corn on the open market and receive the higher price harvest were below the option price, on the other hand, the farmer could exercise the option, thus ensuring h i mself the price he had been counting on A government agency would determine This proposal, however, faces the same incentive problems as There is no reason to think a public agency can It may well be that govern If the corn price at The purchaser of a Ifp utlf option, which Harold Demsetz Information and Efficiency: Another Viewpoint Journal of Law and Economics, April 1969, pp. 1-21.

J. Bruce Bullock Future Directions for Agricultural Policy," American Journal of Agricultural Economics, May 1984, pp. 234-2 39. 10 entitles him to sell a commodity at a specified price, is insured against a decrease in price. conventional futures market hedge, provides security against price decreases. Unlike the conventional hedge, however, the llputlf option allows farmers t o reap the benefits of price in creases Thus, the aputll option, like the There were no markets for I1put1l options in agricultural products from the New Deal era up until 1984 such option markets was not caused by market failure, but rather by a congressi o nal ban on agricultural commodity options in 1936 following allegations of market manipulation. Trading Act lifted the 1936 ban and authorized a three-year pilot program with actual trading of a ricultural commodity options scheduled to begin in late 1984 The absence of The 1982 Futures 9 GOVERNMENTAL INITIATIVES Three steps could move the U.S. to a market-based agricultural production and marketing system 1. Agricultural programs must be changed so that prices of farm Products reflect the underlying suppl y and demand conditions. That is, price support levels should not be above the market clearing prices for wheat, cotton, milk, oranges, and other products. the U.S. government must reduce (not increase) trade restrictions and work to reduce trade barriers i n.other countries In expanding opportunities for exports of farm Products 2. If interest rates are to allocate credit efficiently within agriculture and between agriculture and other sectors, the price of credit must reflect the actual cost of credit This means that credit subsidies on loans by the Farmers Home Adminis- tration, the Rural Electrification Administration, and other agencies must be eliminated that create or increase market instability. The sad fact is that market instability in agriculture d u ring the past decade has been largely attributable to government policies. The most important contribution the federal government could make toward reducing risk and instability in U.S. agriculture would be to pursue stable and noninflationary monetary an d fiscal policies. ing a stable legal framework for businesses engaged in agriculture is also important in the development and operation of futures markets, option markets, and other market institutions to reduce risk 3. The government must eliminate or re d uce those policies Provid l9 David E. Kenyon, Farmer's Guide to Trading Agricultural Commodity Options, U.S.D.A. Agriculture Information Bulletin Number 463 (Washington, D.C U.S. Goverient Printing Office, 1984 11 CONCLUSION U.S. agricultural policies hav e been designed to raise Today's agricultural surpluses can be attributed directly product prices above the market price ever since the New Deal era. to government price support programs in which farm product prices have been supported at artificially high levels. As such, the most effective means of eliminating surpluses of grains, milk, or other products is to eliminate price supports. Attempts to solve overproduction problems throuqh payments to producers, land retirement, and other means misallocate res o urces and require restrictions on imports to prevent domestic consumers from pur- chasing cheaper imported goods It is inconsistent for agri- cultural producers to support protectionist domestic policies for their own products while simultaneously advocat ing freer inter- national trade.

The competitive entrepreneurial market process is just as applicable to agriculture as to other economic sectors. enterprise system is unique in its ability to harmonize resource use and to accommodate consumer demand effec tively process can only be fully effective if market signals, including prices profits and interest rates reflect constantly changing economic conditions. Economic regulation and taxation of entre- preneurial returns thus will affect resource use adversel y The free The market Government programs always have consequences that were not, and cannot be, foreseen. This creates pressures for new programs to deal with these unanticipated problems. Department's Payment in Kind (PIK) program in 1983, for example, w a s devised to deal with the problem of surpluses created by the government's price support programs. The PIK program, however, reduced sales of farm equipment, fertilizer, and other agri- cultural inputs, thereby hurting firms selling these inputs. To reme dy this, Congress made agribusiness firms eligible for sub- sidized FmHA loans in 19

84. In this example, as is often the case, the abruptness of changing economic conditions can be traced to government policies. That is, government policy is frequently a source of uncertainty rather than a source of stability achievements, and there is abundant ev-idence that, judged by its ability to produce goods and services, the market system is a phenomenon unique in world history.20 Moral issues pertain as well, sin c e a persuasive case can be made that prohibitions on mutually beneficial market exchanges are not fundamentally dif- ferent from restrictions on First Amendment rights.21 The Agriculture The market is often justified on the basis of its productive It is 2 o 21 Paul Johnson Has Capitalism a Future The Freeman, January 1979, pp 47-50.

Ronald Coase, "The Market for Goods and the Market for Ideas," American Economic Review, May 1974, pp. 384-391. 12 ironic that human rights issues are so heavily discounted or i gnored in discussions of restrictions on economic freedom It is argued, for example, that agricultural programs that restrict competition are not authoritiarian, because no production control program in agriculture "has been engaged in without a favorable vote by farmers.'122 rights occurs under majority rule, however, does not eliminate the human rights issue involved. Similarly, if economic rights are similar to First Amendment rights, the fact that a plebiscite precedes compulsion in the case of marketi n g orders and other government-sanctioned restrictions on competition does not dispose of the ethical issue. The voting in such cases excludes the much larger number of taxpayers and domestic and foreign consumers who bear the cost of the programs people t o make voluntary economic transactions with each other is central to questions concerning the appropriate role of govern- ment in agriculture and other sectors of the economy. In what George Mason University economist James Buchanan has labeled the Ifmoral l y relevant" science of political economy, the focus is on the institutional framework that provides the greatest oppor- tunity for individuals to pursue their own diverse ends through decentralized coordination of their activities. The policy implication o f this market-based approach is that the maximum scope for individual choice should be provided. Only in this way can the nation's agricultural resources be used most economically, serving the interests of farmers, consumers, and taxpayers alike The fact that an infringement of civil The notion of individual rights, including the rights of Prepared for The Heritage Foundation by E.C. Pasour, Jr 22 Harold F. Breimyer, "Conceptualization and Climate for New Deal Farm Laws of the 1930s 1983).

D. 1156.

Americ an Jokal of Agricultural Economics (December I A 23 James M. Buchanan The Related But Distinct 'Sciences' of Economics and of Political Economy," British Journal of Social Psychology (1982), pp 175-183 Professor of Economics and Business, North Carolina S tate University.

The author wishes to thank M.A. Johnson for helpful comments.

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